The People’s Bank of China said on its Web site on Sunday that big banks would have to hold 11 percent of their deposits in reserve at the central bank beginning on May 15, up from 10.5 percent now.

The 0.5 percentage point increase, the fourth increase in reserve requirements this year and the seventh since June 2006, will tie up an estimated 170 billion yuan ($22 billion).

Over the last year, the central bank has also raised interest rates three times — most recently on March 17. Economists said the decision to raise required reserves made another increase in borrowing costs unlikely in the short term.

Over the last year, the central bank has also raised interest rates three times — most recently on March 17. Economists said the decision to raise required reserves made another increase in borrowing costs unlikely in the short term.

April 30 (Bloomberg) -- Excluding housing, the U.S. economy is doing just fine.

That's the latest rationalization of a select group of operators who think that the Bush administration's 4.6 percentage point cut in the top marginal tax rate and 5-point reduction in the top capital gains rate can protect the economy from any and all ills.

To say that ex-housing the economy is doing just fine is tantamount to claiming that, ex-Iraq, Bush's Middle-East policy is a rousing success.

How valid is the claim that outside of housing everything is hunky dory? Let's go to the videotape to see how housing- centric the U.S. economy's weakness really is.

The Commerce Department reported Friday that real gross domestic product rose 1.3 percent in the first quarter, the slowest pace in four years. The year-over-year growth rate slipped to 2.1 percent, also a four-year low.

Investment in housing, the purported culprit, fell 17 percent, less than in the fourth quarter. Residential investment, as it's known in the GDP accounts, subtracted from growth for the sixth consecutive quarter, something that hasn't happened since 1980.

The first quarter's sluggish growth wasn't confined to housing, however. Exports declined, inventories were a small drag, and capital spending (investment in equipment and software) rebounded 1.9 percent -- better than expected based on monthly data on shipments but nothing to write home about after declines in the second and fourth quarters of last year.

``The initial weakness was in housing, but the weakness in capital spending is not a cross-infection from housing,'' says Ian Shepherdson, chief U.S. economist at High Frequency Economics in Valhalla, New York.

Housing PlusOne year ago, capital spending was growing at a 9 percent year-over-year rate, he points out. Now it's zero.

``A year ago, people said capital spending was going to rescue us as housing slowed,'' he says. ``Capital spending is down to zero (year-on-year). There's been an unambiguous slowdown.''

In only one quarter of this entire expansion did capital spending add 1 percentage point or more to growth compared with an average contribution of 1 percentage point from the end of 1992 through the middle of 2000. The first-quarter contribution was 0.1 percentage point.

``Are businesses going to step up their pace of capital spending with the utilization rate falling and consumer demand slowing?'' asks Paul Kasriel, director of economic research at the Northern Trust Corp. in Chicago.

He clearly doesn't think so.

Boxes of Wallboard?The American consumer keeps on trucking at a healthy pace. Consumer spending rose 3.8 percent last quarter, the only sector outside of government to contribute to growth.Granted it's the biggest sector of the economy: 70 percent in 2006. But even the consumer is showing some signs of fatigue.

The rate of growth in retail sales has slowed in the past year, High Frequency's Shepherdson says. He uses a measure of core sales, which strips out building materials (the GDP ex- housing crowd can relate to that), price-driven food and gas, and autos, and is growing at a 4.7 percent pace now compared with 8.6 percent in March 2006.

Companies that haul the stuff consumers buy -- United Parcel Service, for example -- are reporting weakness in their domestic operations. UPS, the world's largest package-delivery company, said U.S. volume showed no change in the first quarter from a year ago.

Excluding EverythingAnother quarter of growth with a 1 percent handle is apt to make Fed officials nervous for the simple reason that there is no mandate for a recession with inflation running at 2-something percent. When growth is that slow, all it takes is a big quarterly inventory decline to thrust a negative sign in front of GDP, which in turn leads to a diminution in confidence.

While Fed Chairman Ben Bernanke's reaction function is different than Alan Greenspan's -- he's not a politician, looks uncomfortable at hearings, and keeps his answers short and to the point -- he isn't immune to what's going on around him.

Imagine how it would look if Congress were to ask him to explain why the Fed let the economy slip into recession with inflation so low. Would Bernanke be able to keep a straight face when he told them that GDP ex-housing was solid?

Heck, GDP excluding consumer spending, business investment, housing and exports was robust in the Great Depression, too.

Unfortunately, investors are currently engaged in wild-eyed double counting, imagining that higher per-share earnings figures and higher repurchases are separate effects, when they are one in the same. The truth is that a significant portion of the higher per-share figures is the result of repurchases, and the higher repurchases are the result of a paucity of alternative uses for the cash.

To put some numbers on this, Bill Hester notes that according to Bloomberg, among S&P 500 companies reporting to-date, the average surprise on operating earnings (cough) per-share has been 9.66%, while the average surprise on operating earnings on a total dollar basis has been 5.85%. Of course, the average is skewed by a few extreme outliers (for example, Hasbro reported operating EPS of 19 cents, versus an estimate of just 1 cent). The median surprise, which is a more robust measure, has been 2.94% in operating earnings per share, and just 1.93% in operating earnings themselves

It is wrong to hail an increase in per-share earnings as if it is an “earnings surprise” – as if it reflects an improvement in corporate operating conditions, when it is in fact an expenditure of existing earnings on shares instead of on business investments. When such repurchases are done at rich valuations, they are a signal that the company lacks other productive business opportunities and is instead propping up per-share earnings by disposing of what it does earn.

Why haven't investors figured this out? The story constantly repeated on CNBC is that companies low-balled their earnings guidance in order to surprise investors with better than expected earnings (with the implication that the market will rise forever because companies can continue to do this indefinitely). A good part of the true story is that analysts made their forecasts of per-share earnings based on old, higher share counts, so the juiced per-share figures resulting from repurchases are now showing up as “earnings surprises.”

As Standard & Poors itself warned last year,“S&P has concern as to the extent that some equity analysts incorporate share changes into their analysis. If a higher share count is used in the calculation of an estimate, the result would be an under estimation of the EPS. This could lead to an initial assumption of a positive earnings surprise when the actual EPS is announced, since the announced value is higher than the estimated value. The discovery that the variance is due to share change, however, would not take long, resulting in any initial upward price movement being negated.”

U can’t touch thisDario keeps handing us sticks to beat him with. After telling us about his pink mountain bike last week, he recently revealed his most recent music purchase: MC Hammer. This makes his criticism of Rob’s musical tastes (the Pet Shop Boys and Abba) look pitiable. Obviously, this has very little to do with the subject of today’s Overnight Report, which focuses on the US and UK housing markets. Except that markets clearly believe it’s ‘Hammer time’ for US housing, while UK housing is ‘Too Legit to Quit’. But if you ask me, it’s UK homeowners who need to Pray’ (Perkins tells me these are MC Hammer song titles – we’ve hit a new low).

i can´t stand mc hammer so i´ve taken the "family guy" version :-)

Tim has outlined our view on the US housing market in previous Overnight Reports,so there’s little point in repeating the analysis. In short, we remain optimistic that the economy will prove resilient to problems in housing and the worst could already be behind us.

> very optimistic...i disagree

> extrem optimistisch. ich denke wir sehen gerade erst den anfang

Yet despite our upbeat view, we recognize why investors are concerned. If problems in sub-prime cause a broader credit crunch across the economy, we could end up looking pretty silly (a feeling familiar to some of us – Ed). Still, there seems to be an inconsistency here. Markets appear relatively relaxed about the UK housing market, which looks more vulnerable to a correction.

At this stage, I should probably clarify something. We don’t deny that US housing is overvalued. House prices will need to fall in real terms over the medium term. Yet given solid employment growth, rising incomes and – most importantly - unusually low long-term interest rates, it seems possible to rationalize where we are now.

In contrast, developments in the UK look harder to explain. Still, it hasn’t stopped some from trying. We are told the lack of spare land, rising immigration and demographic factors justify the premium on UK housing. But I’m yet to be convinced. These factors should boost prices and rents by a similar amount, as marginal buyers are forced into the rental market. Yet prices have risen far more quickly than rents over the last decade. The ratio of house prices to rents is now almost 50% higher than its long-run trend, compared with around 25% in the US. In fact, prices have risen so much faster than rents that rental yields are now below mortgage rates. In other words, property ‘investment’ is generating a negative cashflow. It’s only the expectation of further capital gains that is sustaining demand.

With house prices appearing more detached from fundamentals, the UK housing market could be more vulnerable to a correction than the US. There are also reasons to believe this could be more problematic for the wider economy. Owing to the lack of supply flexibility (economists call it an ‘inelastic’ supply curve), the burden of adjustment would fall on prices rather than quantities, the opposite to what we have seen in the US (see the illustration on page 2). This is how ‘spillover’ effects could occur. Falling house prices would depress household wealth and spending, especially as UK consumers hold a larger share of their wealth in housing than in the US. And given the concentration of default risk and sharper increases in household debt, the banking sector could also be exposed. While the latest RICS survey shows UK housing is still ‘Gaining Momentum’, we all know ‘This is the Way We Roll’: a housing market collapse will undermine confidence in sterling, preventing the Bank of England from cutting rates and prolonging the downturn.

It seems puzzling that markets worry about excesses in the US, but remain relatively unconcerned about the situation in the UK. The UK has experienced much sharper increases in house prices than nearly all other developed economies in recent years (Chart 1). Is this justified? We think not.

Numerous attempts have been made to rationalize the premium on UK housing. These arguments generally highlight the shortage of supply or a sustained increase in demand (due to immigration or demographics). Yet these trends arenot exclusive to the UK. The Netherlands and Japan have more acute land shortages, but have experienced less rapid increases in house prices

More significant, an increase in housing demand or shortage of supply should put upward pressure on rents, as well as on prices. Over the long-term, rents and house prices should grow in line with each other. Yet this has not been the case. Prices have risen much more rapidly than rents in recent years, suggesting UK housing is overvalued by nearly 50% compared with about 25% in the US (Chart 2).

Rather than fundamentals supporting the housing market, expectations of future gains and speculative activity seem to be driving prices higher. The level of rental yields is perhaps the clearest evidence of this. In the UK, rental yields have fallen below mortgage rates (Chart 3). This implies that housing ‘investment’ is generating a negative cashflow. With buy-to-let demand now accounting for 25% of all new mortgages, this illustrates how fragile demand could be to a shock to expectations.

This greater degree of overvaluation makes UK housing more vulnerable to acorrection than the US. It could also have more significant implications for the wider economy. Owing to the lack of land and inelastic supply, the burden of an adjustment would fall on prices rather than quantities. A given change in demand will generate a larger drop in prices (Chart 4). In regions where land is more abundant, such as the US, the adjustment primarily comes through quantities (i.e. construction output). A fall in UK house prices would depress household wealth, hurting consumer spending. It could also leave the banking sector exposed. If sterling then collapses, the Bank of England could find itself unable to respond.

lets hope abn is allowed to "stay" with their view after their takeover from the british barclays.......

....Standard & Poor's reported yesterday that the S&P/Case-Shiller 20-city composite index in February was down 1% from a year earlier. The metro-area price changes ranged from drops of 7.8% in Detroit and 5% in San Diego to rises of 10.6% in Seattle and 7.7% in Portland, Ore. In 15 of the 20 cities, March prices were down from a month before....

In Florida's St. Lucie County, current inventory is enough to last more than 34 months at March's sales rate, says Mr. Lawler. The supply is 29 months in Palm Beach County and 25 months in both Miami-Dade and Broward counties, he adds.

Other cities with big increases in listings from the already swollen levels of a year ago include Phoenix (36%), Chicago (44%), Los Angeles (54%) and Las Vegas (30%). The inventory was little changed but still plentiful in the San Diego and Washington, D.C., areas...

At the same time, delinquent mortgage payments -- a precursor of more foreclosures -- are on the rise. Lenders sent 46,760 default notices to California homeowners in the first three months of this year, more than double the year-earlier tally and the highest in nearly 10 years, according to DataQuick Information Systems, a research firm in La Jolla, Calif. Defaults were particularly prevalent in Sacramento, Riverside and San Joaquin counties

The Dow made another record high yesterday as it crossed the 13,000 level for the first time. To provide some perspective to the current Dow rally that began in 2002, all major market rallies of the last 106 years are plotted on today's chart.

Each dot represents a major stock market rally as measured by the Dow. So what does this chart show? As it stands right now, the current Dow rally would be classified as long in duration (now the fourth longest since 1900) but below average in magnitude. Stay tuned...

BUY now while stocks last. The retailers' traditional slogan is being re-enacted in the American stockmarket. The supply of quoted shares is shrinking fast.

The biggest buyer is the corporate sector itself. According to Tim Bond, of Barclays Capital, American companies acquired (via takeovers and buy-backs) some $602 billion of shares last year. In the fourth quarter, the pace of purchases was running at an annualised rate of 6% of the entire market. April 23rd was the biggest day for takeover announcements since the AOL/Time Warner deal of January 2000 and the following day saw IBM announce a $15 billion buy-back. With that kind of support, it is hardly surprising that investors can shrug off economic and geopolitical concerns and push the Dow Jones industrials to a new record above 13,000, as they did on April 25th.

Mr Bond says this equity-buying splurge is almost exactly matched by the corporate sector's financial deficit—in other words, companies are borrowing money to buy back shares. This gearing up of the balance sheet is occurring when profit margins are at their highest level since the 1950s. It looks like hubris....

Smithers & Co, an economic consultancy, takes a gloomy view, arguing that American profit margins are reverting to the mean and thus the prospects for company earnings are all downhill from here. It has observed an inverse link between profit margins and personal savings, which are very low in America. This creates the risk of a vicious circle in which any fall in the stockmarket will push up personal savings, depressing profits and hurting the stockmarket further.......Despite good results so far, HSBC says forecasts for 2007 earnings per share for S&P 500 companies have edged down from $95 in the middle of last year to less than $93 today. And Dave Rosenberg, a Merrill Lynch economist, says that, over the past six months, business sales have fallen at an annual rate of 2.3%.

If business conditions are getting more difficult, a bit of financial engineering will help. Buying back shares with borrowed money boosts earnings per share, so profit growth can continue to look healthy. That was an important driver in the final stages of the 1990s bull market.

>here one example from the builders. and at the same time they have bought back stocks.

More than half, or 11, of the 21 builders that Moody's rates failed to generate more cash than they spent in 2006, analyst Joseph Snider in New York said in a report today

Pulte was one of three investment-grade companies generating negative cash flow for the previous 12 months at the end of the year, Snider said. The other two are Dallas-based Centex Corp. and Toll Brothers Inc. in Horsham, Pennsylvania.

In the long run, this is not sustainable. But so far, investors do not seem to have noticed. Slowing profits forecasts have been offset by an increase in the prospective profits multiple on American shares. Corporate borrowing rates are at cyclical lows, increasing the incentive for companies to buy back shares and for private-equity groups to launch takeovers. For as long as that buying spree continues, those who worry about the long-term will look out of touch.

> the homebuilder etc have been forced to shift priroties to be bondholder friendly within a quarter. things can change very quickly.

Tens of millions of Chinese are risking their shirts in a stockmarket frenzy. If it goes wrong, things could get nasty

WOULD-BE share punters, keen for a piece of China's booming stockmarket, are queuing to open accounts at a Beijing branch of China Merchants Securities. ..... Bunches of small investors, ranging from students to pensioners, crowd around computer terminals to carry out their trades, keeping an eye on the prices as they flicker across big electronic screens. China's biggest-ever stockmarket boom may be turning into a bubble—and the country's leaders are getting worried.

If the bubble were to pop, it could have a bigger impact on social stability than any previous downturn in the stockmarket's 16-year history. There are now more than 91m accounts held by individuals at brokers or in mutual funds. Estimates for the number of investors vary widely. At the height of the last market boom, in 2001, there were 60m accounts but perhaps fewer than 10m investors. There are certainly many millions more now. New accounts at brokers are being opened at a rate of more than 200,000 a day, touching a high of more than 310,000 on April 24th.The total so far this year is more than 8m, which is around ten times as many as in the whole of 2005, when the market began to emerge from a four-year slump. ......

The Shanghai composite index for yuan and hard-currency shares is now approaching 4,000, a rise of nearly 40% so far this year after a 130% increase in 2006 (see chart).

Some economists fret that share prices are moving far ahead of companies' earnings, to a degree scarily reminiscent of Japan in the late 1980s just before its crash. With the help of new share listings, the combined market value of the Shanghai and Shenzhen exchanges has risen to some 15 trillion yuan ($1.8 trillion), 87% more than at the end of last year and surpassing that of Hong Kong.

The growing involvement of low-income groups such as students and pensioners, who were more cautious during the last bull run, could make a crash more painful. Mr Xing says 20-30% of economics and business students are playing the markets. ....

So many employees are spending their time trading stocks online that some companies have introduced fines to deter them. But many continue surreptitiously trading and sharing tips through e-mails, instant messaging and texts. Mobile-telephone users (that is, almost every adult city-dweller) can subscribe to stockmarket alerts and trade shares simply by pressing buttons on their handsets.

Another big change is the ready availability of mortgageable or pawnable assets with which to raise money to buy shares. Since the late 1990s, the privatisation of urban housing has given many people a stake in rapidly appreciating property. And with consumer-price inflation creeping up to a two-year high of 3.3% at the end of March, real interest rates have been around zero or negative this year. This has encouraged the withdrawal of savings from banks. Hou Ning, a Beijing-based analyst, says that in the countryside unlicensed moneylenders have been helping farmers into the markets with unsecured high-interest loans.

> at least they have not yet all the creative loans/instruments like in the us.......

China's leaders are worried, but unsure what to do to cool the market. A string of interest-rate rises and increases in banks' reserve requirements have had little effect so far. Like their fellow communists in neighbouring Vietnam, where a similar stockmarket bubble has grown, they know that share gains keep the rising middle class contented and help the state's big privatisation programme. But if tens of millions of urban Chinese lose their shirts, they could turn their anger on the party.

Twice this year—on February 27th and April 19th—the markets have wobbled alarmingly amid rumours of tougher measures to control the flow of cash. The latest upset was caused by figures showing the economy growing even faster than expected: in the first quarter of this year, output was up 11.1% on the same period of last year. But the bulls have quickly returned. Outside the China Merchants Securities branch, a group of investors debates the market's prospects. “It's like a casino set up by the Communist Party,” says one. Another says only fools are still investing. But none has any plans to cash out

> looks like the 6th raise of the Bank Reserve Ratio in the past 10 month plus several rate hikes plus other attempts to cool things down have failed poorly. maybe they should combine a hike and the raise of the reserve ratio to gain control and respect.

Shanghai-traded shares of China Citic Bank Corp. more than doubled on their first day of trading after a $5.4 billion stock sale, the world's biggest this year.

``People don't mind paying a bit of a premium'' if they are comfortable with the growth outlook, Binay Chandgothia, who helps manage $1.6 billion as chief investment officer at Principal Asset Management Company (Asia) Ltd., said today in Hong Kong. ``There's demand for new stocks.''

April 20 (Bloomberg) -- China's construction stocks have become the most expensive in Asia on record spending for roads and bridges, just as the government is taking steps to slow economic growth.

The country's building and machinery stocks trade on average for 166 times profit for the past year, according to data compiled by Bloomberg. That's about nine times the price-earnings ratio for the average company in the Morgan Stanley Capital International Asia-Pacific Index, and higher than construction stocks in any other country in the region...

>but on the other hand look at some us homebuilders. after their charges they have almost no earnings to calculate the pe........ ( i know not quite apples to apples)

Chinese construction stocks have gained 117 percent this year on average, boosted by a record $366 billion in spending on roads, ports and power stations last year. That compares with a 4.7 percent rise in the MSCI Asia-Pacific benchmark. Eight of the 10 most expensive Asian stocks in the industry are traded in Shanghai or Shenzhen.

Below PeakWhile Chinese construction stocks are down an average of 3.6 percent from their peaks of the past year, they still contributed to a 54 percent surge this year in China's benchmark CSI 300 Index, the biggest gain in Asia. The CSI 300 closed at a record this week.

Changsha Zoomlion trades at 42 times profit, the highest since 2003, according to Bloomberg data. The stock has averaged 16.5 times profit over the past four years.

Sany HeavySany Heavy Industry Co., the country's largest maker of machinery for handling concrete, is valued at the highest price relative to profit since July 2004. The shares, trading at 53 times current profit, are more than five times more expensive than in November 2005 when they were worth 10 times. ....``Most Chinese infrastructure companies have strong order books and high earnings visibility,'' said Maggie Lee, who helps manage the $450 million Invesco Asia Infrastructure Fund at Invesco Hong Kong Ltd. ``Under the current environment, you won't really find any other sectors in China that will deliver the same kind of sustainable growth over the next five years.''Lee said she continues to hold more Chinese infrastructure stocks than represented in her fund's benchmark.

Rising DemandDemand for construction machinery in China will grow 15 percent annually in the five years through 2010 to 250 billion yuan, BNP Paribas Peregrine Securities Ltd. said in a November 2006 report.

Shares of Changsha Zoomlion have risen fourfold in the past 12 months. Sany Heavy has surged almost eight times in the period, and China Construction is up 61 percent since its stock market debut in Hong Kong on Dec. 15.

Thursday, April 19, 2007

the real "stress test" of the derivatives market will be one of the main topics. when the suprime derivatives are any guide .....

pimco has written "with innovation comes risk". http://tinyurl.com/384a2h so far the risky part of the derivatives has shown his ugly face only in the subpirme sector. we all know that leverage works both sides......

on top of this excellent report from the economist it seems very difficult to account derivatives. when even ge has problems http://tinyurl.com/2cdfhh .... and the biggest problem that is left out in the report is that hedge funds are a domnant player in this segment. what about counterpartyrisk?

The use of credit derivatives has boomed and bemused. These new financial instruments have yet to face their biggest test

NAUGHTY or nice? The question that Father Christmas poses to every child who clamours for a present also haunts the credit-derivatives market. Are these devices a clever way to disperse risk, making the financial system safer, as their enthusiasts claim? Or are they “financial weapons of mass destruction”, in Warren Buffett's phrase, that are poorly understood and perilous boosters of credit?

So far the optimists have had the better of it. People have worried about financial derivatives for 20 years, but economies have proved remarkably resilient. These exotic instruments have not yet produced the cataclysm that Jeremiahs have long forecast. Indeed, the equity bear market of 2000-03 did not result in a banking crisis, as it might have done 30 years ago, when derivatives were still rare.

So far credit derivatives have proved a triumph of the financial sector's ingenuity. By dividing the bond market into digestible chunks, they have increased investors' appetite for corporate debt. That may well have lowered the cost of capital—good for the economy, since it should allow companies to invest more over the long run.

But credit derivatives have yet to face a really bracing test. They have grown in a time of low interest rates and narrow credit-spreads (an extra yield over government bonds to offset risk). Recent problems in America's “subprime” mortgage market (for borrowers with poor credit ratings) are a reminder that the sun does not shine for ever. What will happen when monetary policy is tighter, with interest rates increasing and spreads widening? The risk of defaultCredit derivatives are financial instruments that “derive” their value from the bond market. They can cover any bonds that are not issued by governments—that is, where investors face the risk that the borrower may not repay.

Their rapid growth stems from three market quirks. The first is that a traditional corporate bond bundles together a whole group of risks. A bond price might fall because investors are generally demanding higher yields for all fixed-income assets (interest-rate risk), because investors prefer bonds of one maturity date to another (duration risk), or because they think the company that issued the bond will have trouble repaying it. Derivatives separate this last factor—credit risk—from the other two.

This allows investors to insure themselves against the risk of default or, alternatively, to speculate that a default will occur. The instrument that does this is a credit-default swap or CDS (see jargon guide). Hence A agrees to pay a series of premiums to B; who agrees to compensate A if the bond defaults. ....

The third quirk of credit derivatives is that they allow corporate bonds to be sliced and diced on the basis of risk. Some investors (such as banks and insurance companies) may prefer to own the highest-rated (AAA) debt for regulatory or solvency reasons. Others, such as hedge funds, may want to take more risk and earn higher returns.

Derivatives known as collateralised debt obligations (CDOs) are a clever way to satisfy every taste. They are like a mutual fund that bundles together bonds, loans or swaps. But unlike a mutual fund, a CDO has different tranches that give investors different rights over this portfolio. For example, as interest payments on the underlying bonds come in, they will first be allocated to the senior tranches. Only when these have been paid will the more junior tranches get their share. And if defaults occur, the junior tranches take the first hit.

This tailoring can turn coarse corporate cloth into investment-grade haute couture. Take a bunch of companies, with bonds rated A (not the best credit-rating, but reasonably secure). Assemble them in a portfolio and give one group of securities rights over the first 70-80% of the cashflows from the bonds (and protection against the first 20-30% of defaults). Since it is highly unlikely that 20-30% of the A-rated bonds will go bust, the rating agencies will give such securities the highest AAA appellation. In a world where very few individual companies can command such a lofty rating, this transmutation makes such instruments highly appealing.

Of course, it concentrates the risks in the rest of the portfolio. The lowest-rated securities (the last to get the cashflows and the first to bear the brunt of default) are known as “equity”. Although they are not strictly shares, they do tend to offer share-like returns of 15-20% or so. The securities in between the equity and the senior securities are known as mezzanine.The bottom tiers of these CDOs have been called “toxic waste”. But they have been almost nourishing in recent years, thanks to the low default rate on corporate bonds. Their buyers have enjoyed the rewards without seeing much of the risks.

That now seems to be changing—in one part of the market, at least: CDOs that buy asset-backed securities and in particular those linked to subprime mortgages. These loans were bundled together and sold as residential mortgage-backed securities (RMBS); in turn those securities were bought by the issuers of CDOs. With so many subprime borrowers now behind on their payments, the pain is trickling through the system. The ABX index, which represents a basket of credit swaps on bonds tied to high-risk mortgages, fell more than a quarter in the first three months of the year.A study by Moody's, a credit-rating agency, of asset-backed CDOs found that, on average, slightly less than half their portfolios were invested in subprime RMBS. But in some cases, the exposure was nearly 90%. http://tinyurl.com/2j382a Losses will be magnified for investors in the junior tranches. At worst, Moody's says, the vast majority of tranches in such CDOs would be downgraded to junk-bond status.

Over the edgeImagine a geared hedge fund owning the riskiest tranches of CDOs exposed to subprime debt. Lombard Street Research reckons that the combined gearing could reach 54-fold, implying that a 2% price drop could wipe out the entire portfolio. There are no signs, as yet, that any hedge funds have taken such a big bet; the best known casualty is a London-listed fund, Queen's Walk, which has seen its shares fall by 40% this year. Anecdotal evidence suggests many hedge funds were quick to realise the dangers of subprime lending—and to profit from the market collapse.

Yet the damage may take time to be felt. Many 2006 mortgages are not yet in default. Many CDO tranches are rarely traded, so prices may not have registered a hit. Investors may not write down holdings until the rating agencies downgrade them—which could take months.

CDOs come in a variety of forms. “Cashflow” CDOs are normally based on a portfolio of bonds.

According to the Bank for International Settlements, some $489 billion-worth were issued in 2006, a record year. Synthetic CDOs are built on swaps: the CDO vehicle insures a portfolio of bonds, doles out the premiums to investors and then deducts capital from the riskiest tranches when defaults occur. The bank says $450 billion of synthetic CDO issuance occurred last year, more than double the 2005 level. Collateralised loan obligations (CLOs) are backed by a portfolio of loans, usually those raised by private-equity groups for takeovers. This area of the market is also expanding fast.

But those are just the straightforward recipes. The ever-inventive financial sector has taken the ingredients and cooked up a bewildering alphabet soup. A CDO2 invests in other CDOs. CPDOs are constant proportion debt obligations which can borrow up to 15 times their capital to insure an index of bonds (such as the iTRAXX) against default; the result is a highly geared structure that pays up to two percentage points above cash rates and yet is given an AAA rating. Credit-derivative product companies (CDPCs) act as a kind of reinsurance company, trading swaps with CDS dealers. They gear up their capital 30 times, relying on the margin between swap spreads on investment-grade debt and the prospects of default. It may sound risky, but Tom Jasper, of Primus Guaranty, one of the sector's pioneers, says he has not suffered a credit default in the five years of the company's existence.....

Systemic risk is more of a worry. Dispersing risk ought to make the system more secure. When a bank fails because of loan defaults, depositors at other banks lose confidence; the result can be a contraction of credit in the economy. If loans are held by investors, such as hedge funds, in diversified pools, corporate defaults should have less of an effect. Each investor should lose only a fraction of its portfolio......

Widening credit spreads will hit some investors (although, of course, those on the other side of the deal will profit). But Lisa Watkinson, of Lehman Brothers, says she does not think the growth of the CDS market will suffer. “The more volatility there is, the more scope you have to express a view,” she says. “When spreads were very low, people were saying there was no need to hedge.”

However, credit derivatives create a moral hazard. Someone has to lend money in the first place. If they know they will sell on that loan or bond within weeks, they may not worry whether the borrower will repay in five years' time. Indeed, if they get paid a fee to make the deal, they will care more about quantity than quality.

In addition, if risk is too diversified, who will monitor credit quality closely? This is the “toddler by the swimming pool” problem. If one parent is in charge, he will never take his eyes off the moppet. But if both parents and others are around, all may assume someone else is on guard. Everyone may be reading their newspapers when they hear the splash.

The holders of the equity tranches should act as the concerned parent, because they will suffer first if defaults rise. However, it may be more difficult for them to do so if they are two or three removes away from the borrower in question.So the system may seem to have become safer, but new dangers could be in the making. Perhaps credit derivatives will alter the behaviour of investors and companies, encouraging them to take more risk. That seems to have happened in the American subprime mortgage market, where underwriting standards fell sharply in recent years, leading to a rapid rise in delinquent loans. Perhaps corporate borrowers will default more than derivative investors imagine, or perhaps investors will recover less value when they do default.

In other words, if individuals feel safer they may act less responsibly. This is the “seatbelt problem”: motorists wearing belts may drive faster knowing they are less likely to go through the windscreen if they have an accident. The overall level of risk ends up the same.

Money mattersA second, and potentially just as serious, problem could be the effect of derivatives on the global supply of credit. David Roche, of Independent Strategy, argues that derivatives have created a form of liquidity outside the control of central bankers. “It is pretty obvious that if one can buy a security that represents an asset for 3-5% of its value, an awful lot of liquidity has been freed up,” he says. “Derivatives have led to many more assets and liabilities being created. By reducing the cost of buying assets, you increase the demand.”

People tend to think of two types of money: narrow money (notes and coins) and broad money (bank accounts and other kinds of assets). Mr Roche says this structure is like an inverted pyramid, where the top layer is derivatives, worth more than nine times global GDP. Credit derivatives are only a small part of this, but already the amounts involved are staggering.

According to the Bank for International Settlements, the nominal amount of credit-default swaps had reached $20 trillion by June last year. With volumes almost doubling every year since 2000, some reckon the CDS market will soon be worth more than $30 trillion

This derivatives “money” is not being used to buy food, clothes or cars—which is why there has been no general pick-up in inflation. But it has been used to inflate asset prices, Mr Roche argues.

The danger is things might go into reverse. A rising cost of capital (perhaps from inflation worries) or a rise in risk aversion (due to a pick-up in defaults) might be the culprit. If liquidity falls throughout the system, derivatives will take the biggest hit. But the result, if derivatives have been pumping up the demand for assets, could be a sharp fall in asset prices.

That makes the naughty or nice question hard to answer. So far, credit derivatives have shown their nice side. Their explosive growth has come against a background of generally benign economic conditions, with only modest recessions and low or falling interest rates. Indeed, derivatives have helped produce those benign conditions, by removing some of the financial constraints on growth.

But it is in the nature of capitalism to test new ideas to destruction and to use new instruments as the basis of speculative excess. As Mr Roche puts it: “Credit derivatives are like good things to the Catholic Church. If you have too much of them, they're a sin.” Nobody will be sure how robust credit derivatives are until they have been tested in a severe economic or financial downturn. And that is not something anyone should wish for.